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The Doctor and the Drug Dealer: A Parable of Registered Investment Advisers and Broker-Dealers

“Regulation Best Interest” and the Growing Concern for Conflicts of Interest

While having drinks with David Colton of Gresham Partners, LLC, he made an interesting analogy to describe the fiduciary duties of the registered investment adviser (RIA) and the broker-dealer. He used the analogy of a doctor as a drug dealer, and the conflict of interest that exists within those roles. 

There are different expectations for RIAs vs broker-dealers when it comes to divulging potential conflicts of interest, and luckily those expectations are being modified by the SEC come June of 2020 (more on that later). 

But first, I’ll explain the analogy with a poem: 

You go to your doctor,

And the doctor says,

Take this drug. It will help your head!

Then later that week, 

You see him in town,

And the good doc asks

Did I help your frown?

Is your pain in the past?

You say, Yes! 

He says, Great!

But here’s the catch:

It’s great for you AND my estate!

Does the doctor ever communicate:

I don’t just prescribe those meds for you

I own shares in that company, too.

If you go to the doctor, and the doctor prescribes medicine from the same company she owns shares in, does the doctor have a conflict of interest? What if the doctor is paid for every pill she prescribes? Is that a conflict?

Let’s assume you go to a doctor, and the doctor says: “Look, I am a doctor, and as such, I put my patient’s care first. But I am also a drug salesman, and as such, it is appropriate to put my own interests first. But don’t worry. I will tell you when I am speaking to you as your doctor, and when I am speaking to you as your drug dealer.”

All good, right? Nope. Not even close. And the above is a pretty unrealistic scenario. Yet something like this happens all the time. And while the context is not as important as your health, it is pretty close: your money.

With whom do you invest your money? What I mean is this: Do you have a broker-dealer? An investment adviser? A financial planner? And, do you know the difference?

Below, I discuss the difference between RIAs and brokers, and financial planners.

RIAs vs Broker-Dealers: What’s the Difference?

An RIA and a broker-dealer have similar jobs, but they operate under different regulations. It’s important to know the difference when selecting an adviser

An RIA (that is, a Registered Investment Adviser) and its employees, known as investment advisers, provide advice and guidance about investments to their clients. RIAs are regulated under the Investment Advisers Act of 1940, and they are subject to a fiduciary duty of loyalty. This is a duty to fully disclose conflicts of interest, and a duty to act in their clients’ best interests. An RIA is generally compensated by fees not tied to whether a transaction happens. 

A broker-dealer (commonly just called a “broker”), on the other hand, and its employees, known as registered representatives, engage in the business of buying and selling securities on behalf of their customers. Broker-dealers are regulated under the Exchange Act of 1934, overseen by the SEC, and typically are members of FINRA (the Financial Industry Regulatory Authority). While not fiduciaries, brokers do have a duty to deal fairly with customers and to make a suitability determination before offering a customer any investment. On the other hand, brokers are compensated when transactions happen. They are permitted to recommend investments that put their own interests ahead of the interests of their customers, and they do not have a duty to disclose conflicts of interest. 

The Line Between RIAs and Broker-Dealers is Not Clear Cut

A broker-dealer is required to register as an RIA if she provides investment advice, unless that advice is “solely incidental” to her core transactional business. Brokers who do not register as RIAs, nonetheless, commonly identify themselves as “financial advisers” or “financial consultants” in their marketing materials, even though they rely on the “solely incidental” exemption to avoid becoming RIAs. This is wrong, in my view, but happens because of the lax enforcement of the exemption’s limits.

The concept of RIAs vs broker-dealers is muddied even more, because many firms operate today as both an RIA and a broker-dealer. This is referred to in the industry as being a “dual registrant,” and it is the point of my parable in the poem above. It is utter silliness to think that one firm (and even one person at one firm) can speak to a client as an RIA one moment, then change hats and speak to the same client the next moment. The person on the receiving end may not be able to understand whether she is getting trusted advice from a fiduciary or not. In other words, no amount of disclosure can prevent confusion. 

Reg BI and New Standards of Conduct

The SEC is well aware of the confusion that can plague especially vulnerable retail investors, including the elderly. Not only will the SEC increase its supervision of RIAs, it also adopted the Regulation Best Interest (Reg BI) under the Securities Exchange Act of 1934. Reg BI enacts a “best interest” standard of conduct for broker-dealers who make recommendations for securities transactions/strategies to retail investors. This more formally enforces brokers to act in the best interests of their clients. Brokers must comply by June 30, 2020. 

In addition, the SEC requires brokers and investment advisers to provide a short relationship summary (known as form CRS) to retail investors. This summary clarifies the relationship and the duties that the adviser has to her client. 

Finally, the SEC published interpretations of the Investment Advisers Act of 1940 to clarify the best interest standard of conduct and the “solely incidental” exemption. 

While these changes are important, David Colton and his colleague at Gresham Partners, Wally Head, have always been proponents of keeping standards for RIAs and brokers separate

Rather than develop new fiduciary rules or adopt a uniform fiduciary standard (which for reasons explained in the Gresham white paper would require the adoption of a lower standard than RIAs are currently subject to) … our preferred approach would be for the SEC to simply enforce the Advisers Act … and narrowly interpret its ‘solely incidental’ exemption so that brokerage firms must register as RIAs if they hold their employees out to the public as advisers … (and that) the concept of dual registrants as it is employed today should be eliminated so that one firm cannot provide both Exchange Act and (the) Advisers Act services to the same client.

I agree with Colton and Head. The SEC’s attempt to set similar standards for brokers has the right intentions, but it may confuse investors even more on the difference between an RIA and a broker-dealer. Enough to send them to the doc for a headache.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Alpha, Beta & Other Key Concepts and Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds 2019. This is an updated version of an article originally published on July 30, 2015.]

©All Rights Reserved. April, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™

About Jonathan Friedland

Jonathan Friedland is a senior partner in Sugar Felsenthal Grais & Helsinger LLP’s Chicago office. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts…

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